Macrof05-1
Question from Past Macroeconomics Qualifying Exam (Fall, 2005 - Question one) at George Mason University 1. A good deal of controversy in macro theorizing revolves around the relative merits of Quantity Adjustment and Price Adjustment as providing the starting point for the analytical effort. Old Keynesians and New Keynesians both emphasize Quantity Adjustment, whereas Old Classicals and New Classicals emphasize Price Adjustment. Use simple models to illustrate the macro significance of this distinction, and provide your assessment of the analytical cogency and empirical applicability of these models. Answer So the price adjustment would make sense when there are fairly large moves in demand. Quantity moves makes sense when the moves in demand are small, and the firm does not wish to provoke a nominal price shock for the consumer demand. The firm might take a short-run surplus loss and adjust the price fewer times. The Keynesians (both) see short run aggregate supply curves as horizontal, or elastic. This makes the choice to move to a new demand curve a function of quantity. The classicals basically see the short-run as very short and so the long-run applies. The movement then has to be a movement in price. : See Also: MacroF02-2 Old Keynesians “…I shall argue that Keynesian macroeconomics neither asserts nor requires nominal wage and / or price rigidity. It does assert and require that markets not be instantaneously and continuously cleared by prices.” (Tobin 1993 p. 46) : So there is reason to believe that Nominal Price Rigidity persists, but not enough to assume prices are fixed. This recognizes that the assumption is too strong in its traditional presentation “In continuously price-cleared competitive markets, they (contemporary theorists) know, individually rational behavior implies collectively rational outcomes. But this theorem does not apply if markets and price-setting institutions do not produce perfectly flexible competitive prices. Individual rationality does not necessarily create the institutions that would guarantee “invisible hand” results.” (Tobin 1993 p. 47) : There is a difference between the micro and the aggregate for which we have to have a different set of rules (This is one of the places where New Keynesians depart and try to make micro foundations of nominal rigidities). “The Keynesian insight is that the institutionally fixed nominal interest rate on currency, generally zero, limits the adjustment of nominal interest rates on non-money assets and imparts to them some stickiness even when they are above zero. As a result, after an aggregate demand shock they may not fall automatically to levels low enough to induce sufficient investment to absorb full employment saving. As a result, aggregate demand – consumption plus investment – will fall short of full employment supply.” (Tobin 1993 p. 53) : In the money market there is substitutability between currency and bonds. This is an argument that some rigidity enters through this door. (Classicals assume money is neutral) “Unless the real supply of money is increased by monetary policy or by price reduction the interest rate will fall enough after a negative aggregate demand shock (the same thing as a negative investment-minus-savings shock) to maintain investment-equals-saving equality at full employment.” (Tobin 1993 p. 54) : Builds on the previous quote, shows a key role of activist monetary policy. “Keynes argued that nominal wage would not fall rapidly in response to excess supply of labor. At the same time, he asserted that real wages could fall if product prices rose as necessary to induce firms to expand employment. ..Workers are concerned primarily with relative wages, with how their pay compares with the pay of those to whom they regard themselves at least equal in merit. ‘’’…it does not explain how the relative-wage concerns of employed workers prevail when there are unemployed workers willing to work for less pay – real, nominal, and relative.’’’ “ (Tobin 1993 p. 56) : Here we see how important the role of the labor markets are. The income comes from wages and if wages are changing so is expenditure and by extension the whole of the aggregate market. New Keynesians “Ball, Mankiw, Romer and others style themselves as New Keynesians. Their program is to develop improved microeconomic foundations for imperfectly flexible prices. In the process, they hope to illuminate the paradox that individual rational or near-rational behavior can result in significant collective market failures.” (Tobin 1993 p. 47) : Microfoundations of Macroeconomics Classicals “The big issue between Keynes and his “old classical” opponents was the efficacy of the economy’s natural market adjustment mechanisms in restoring full employment equilibrium, once a negative real demand shock had pushed the economy off that equilibrium. Keynes and Keynesians said those mechanisms were weak, possibly nonexistent or perverse, and needed help from government policy. That is still the major question of macroeconomic theory and policy, even though new classical economists finesse it by assuming that the economy can never be pushed out of equilibrium even for a moment. Keynes’ classical contemporaries and predecessors would never have drawn real-world lessons from theories based on such an assumption. Their successors strain credulity when their models imply that markets are cleared and joblessness is voluntary when measured unemployment is 10 percent as truly as when it is 5 percent.” (Tobin 1993 p. 48) : Here is the argument that classicals are too long-term myopic in their view. Expressed is the relation of Keynesian application to fix present policy concerns. Interestingly there is concern again for the role which unemployment plays in the Keynesian paradigm. “A common species of classical unemployment occurs when jobs are limited because of excessive real wage rates imposed by governmental or trade union regulations. For individuals who would like to work at or below the wage floor, such unemployment is involuntary. For the workers collectively whose bargaining strength or political clout established the regulations, the unemployment could be regarded as the voluntary consequence of their exercise of monopoly power…The big difference between the two cases is that in the Keynesian case, but not in the classical case, real wages would decline on their own and output and employment would increase in response to expanded demand. In the classical case removal of the regulations would be essential.” (Tobin 1993 p. 49) : We do see that the impact of regulation is central to both Keynesian and Clasical differences. The Keynesian perspective is that adjustment is helped through the regulations, the classical view does not conform to this outlook and again seems to be considering the long-term even in the case outside of present policy and into the realm of adjustment. “In old classical macroeconomics, interest rates are the equilibrators of both capital markets and goods markets. Their adjustment is crucial to the Say’s Law story, which dismisses as vulgar superficiality notions that an economy could suffer from shortfalls in demand for commodities in aggregate. Market interest rates keep investment equal to saving at their full-employment levels – and therefore keep aggregate demand equal to full employment output – even if nominal product prices and wages stay put. Indeed classical doctrine is that the real equilibrium of the economy is independent of nominal prices, as if it were the outcome of moneyless frictionless multilateral Walrasian barter.” (Tobin 1993, p. 53) : This part comes out of a discussion of some of Plosser's findings compared to Keynes' views. We see a difference between real and nominal included for further contrast. Classical view: “A concretionary shock in aggregate demand (would cause) deflation of money wages and prices (restoring) real demand to its full employment.” He takes the opposite view “This classical market-clearing adjustment mechanism was …much too fragile to bear the weight of macroeconomic stabilization.” (Tobin 1993 p. 57-58) New Classicals “I am using the word equilibrium to mean Walrasian market-clearing by prices, as is the current usage of both new classical macroeconomists and disequilibrium theorist. Keynes used it otherwise, to refer to a position of rest.” (Tobin 1993 p. 51) : An important distinction. “In standard Walrasian / Arrow-Debreu theory, perfect flexibility of all wages and prices, present and future, would maintain full employment equilibrium. Short of that, an old question of macroeconomic theory is whether, given current nominal wages and prices, changes in future money wages and prices – that is, in nominal interest rates – could do the job.” (Tobin 1993 p. 53) : To the extent that New classicals have addressed this question Tobin remains an old Keynesian. Sources * Tobin, James Price Flexability and Output Stability: An Old Keynsian view in “Symposium: Keynesian Economics Today,” Journal of Economic Perspectives, Winter 1993, 3-82. Other Questions * Next macrof05-2 * Previous macroS05-6